Tax Liability Insurance

Navigating Tax Uncertainty: The Role of Tax Liability Insurance

Asia Risk & Insurance Advisors (ARIA) has experienced a recent uptick in inquiries regarding insurance protection for various tax issues, both corporate and individual, so we thought it timely to provide a refresher on tax liability insurance (TLI), which is also referred to as tax indemnity insurance and tax opinion insurance.

What is tax liability insurance?

Tax liability insurance enables a taxpayer to either reduce or eliminate a potential financial loss relating to the tax treatment of transaction, investment, or other activity where the legal accounting conclusions that supported such a tax treatment could be challenged by the relevant tax authority, in country or foreign.
The policy is tailored to address the specific financial exposure of the insured should there be an unfavorable ruling. Coverage can address the primary amount of tax payable, any interest and insurable fines and penalties due, defense costs including the expenses involved in engaging legal or tax specialists, and gross-up amounts for taxes due on receipt of insurance proceeds.
Tax liability insurance is a specialized risk transfer product designed to protect businesses or individuals from financial losses arising from potential tax liabilities. Below are the key aspects of tax liability insurance.

Coverage Scope

There is no standard tax liability insurance policy wording as each policy is tailored to address the specific tax position that is a concern, however, policies can be designed to address the following tax risks:

• Uncertain Tax Positions: TLI can cover risks associated with uncertain tax positions, where there is ambiguity or potential disagreement with tax authorities on the treatment of a particular tax issue.
• Audit Risks: Covers the costs associated with defending against tax audits and any subsequent tax liabilities assessed by the tax authorities.
• Historical Tax Liabilities: TLI provides protection against unknown tax liabilities that may arise from past tax returns or M&A transactions.
• Tax Credits and Deductions: TLI can protect against the loss of tax credits or deductions that were expected to be realized but are subsequently denied.
• Specific Tax Risks: TLI can be tailored to cover specific tax positions or risks identified during tax reviews, tax planning, or M&A due diligence.

As with all insurance policies, TLI has standard exclusions as well and they likely exclude coverage for changes in law, inconsistent tax filings, and material misrepresentations in the representation letter submitted to underwriters.

Tax Liability Insurance Policy Features

• Indemnification: A TLI policy typically indemnifies the insured for tax liabilities, including additional taxes owed, interest, penalties, and defense costs.
• Policy Limits: The policy will have limits on the maximum amount payable for covered claims, which can vary based on the perceived risk and coverage needs.
• Duration: The policy duration can vary but often aligns with the statute of limitations for the relevant tax authorities.
• Premium: A one-time premium is usually paid at the policy’s inception, although in some cases, annual premiums may be arranged.

Strategic Tax Liability Insurance Uses

TLI has been used to address a wide variety of tax concerns of businesses and individuals.

• Gaining certainty for the treatment of an entity (REIT, S-Corporation, Partnership, etc.)
• Tax treatment of reorganizations, recapitalizations, and/or spin-offs
• Capital gains vs. ordinary tax treatment
• Tax credits for renewables and carbon capture
• Cryptocurrency transaction classification
• International issues involving transfer pricing , foreign tax credits, VAT, private equity status, and treaty qualification
• Real estate concerns regarding property transfers, reassessments, and ownership structures
• Estate planning, gift taxes, and international income tax

Tax Liability Insurance in Mergers & Acquisitions

In most M&A transactions, tax risk evaluation is an integral part of the due diligence (DD) process and, in some cases, discovered tax issues can create an obstacle to closing the deal. TLI helps buyers avoid self-assuming an identified tax risk or negotiating an indemnity/escrow and sellers can be insulated from an indemnity obligation. TLI has been used in a variety of ways to facilitate a transaction.

• In preparation for the sale of a company, a seller can use TLI to address a known tax issue prior to buyer DD to ensure a smoother and more expeditious sale process
• A buyer can differentiate its bid and be more competitive in an auction situation by using TLI to resolve an identified tax issue
• TLI can ring-fence an issue where the seller and buyer are unable to obtain a determination on a tax issue from tax authorities during negotiations thereby allowing the transaction to proceed and close
• TLI can cover a tax issue that is excluded by warranty & indemnity insurance (W&I)
• For private equity firms, TLI can be used to cover potential tax risks in their portfolio companies, purchase and sale negotiations, GP led secondary transactions, capital gains tax determination, and fund wind-ups

Today’s international tax structures and their related business implications have grown rapidly in size and complexity, increasing the chance of an unexpected tax challenge that could significantly compromise the value of a transaction. TLI is an effective risk management tool that is ever evolving to address this risk.

Tax Liability Insurance in South Korea

Interest in tax insurance has grown steadily over the last few years as tax authorities in the Republic of Korea (ROK) have become more aggressive to raise tax revenue … and M&A transactions, past and present, are an area of focus. Asia Risk and Insurance Advisors continues to see new and creative applications of tax liability insurance to address a range of tax concerns in Korea including capital gains tax applicability / identification of beneficial owners and GP-led secondary transactions. Cross-border deals are also a growing area of concern for buyers as tax authorities scrutinize corporations’ tax arrangements, especially for those with multi-country operations. On distressed deals, tax insurance has been sought to protect the debtor and/or buyer from unexpected tax liabilities relating to a debt restructuring, cancellation of debt income, and the ability to use a target company’s net operating losses / NOLs.

Tax Liability Insurance Benefits

An unexpected challenge to a tax structure can significantly impact the value of a company and/or the success of an M&A transaction. Tax liability insurance can be an effective risk transfer tool to protect those that are insured where there is an element of uncertainty regarding the tax treatment relating to a change in ownership of a company, reorganizations, or the historic tax positions taken by a company or its consolidated tax group. TLI provides:

• Financial Protection: TLI is a prudent risk management tool as it provides financial security from a reputable and deeply regulated counter party against unexpected tax liabilities, helping to preserve cash flow and capital.
• M&A Transaction Facilitation: In mergers, acquisitions, or other business transactions, tax liability insurance can facilitate the deal by mitigating tax-related concerns that could complicate negotiations or cause parties to walk from the deal.
• Peace of Mind: Offers peace of mind to business owners, investors, and individuals by reducing the uncertainty associated with potential tax liabilities.

Tax Liability Insurance Takeaways

Tax laws are complex and with complexity comes uncertainty. Taxpayers are often faced with having to take a position on a complex and uncertain tax issue that, if successfully challenged by a tax authority, could have a material financial impact on the taxpayer. Tax liability insurance is a valuable tool designed for managing such risk and bringing certainty to uncertain tax positions.